Bronte Capital

Wednesday, April 1, 2015

Charlie Munger - at the last annual meeting of the Daily Journal Corporation - where Charlie is Chairman - said some pithy stuff about Valeant (and implicitly the CEO J Micheal Pearson). To quote:

Valeant is like ITT and Harold Geneen come back to life, only the guy is worse this time.

Now ITT was not by any stretch the worst of the 1960-70s conglomerates. If Charlie had compared Valeant to (say) Ling-Temco-Vought that would have been a much nastier statement.

But Harold Geneen's monster went from one of the most feared corporations in the world to a sort-of-pathetic has-been. It was rising interest rates and falling stock prices that did him in - although not to the point of bankruptcy.

But before Geneen was done in there was a book written about ITT - The Sovereign State of ITT. One of my staff members owns it - and I have only just got to it.

The book covers mostly left-wing conspiracy stuff about dirty deals done with the Nixon Administration. [They probably all happened - Nixon was like that.]

Whatever - the accounting section tells us that Charlie's comparison was apt. These quotes are extracted from pages 144-7:

As each new acquisition was swallowed up by the ITT whale, so the separate characteristics that had been made clear in its balance sheet went out of sight as completely as Jonah. The separate profits and losses of each industry —whether hotels, rented cars, or house-building—were no longer discernible in the consolidated balance sheet, and the breakdown of sales showed only the most generalized headings: "Defense and Space Programs" or "Consumer Services." The concoction of the corporate accounts thus became a challenge to the art of a master accountant; the profits and losses could be quietly set off against each other without anyone knowing...

Moreover, the multinationality of ITT made it exceptionally able to defend itself against taxation, like a nomadic millionaire. It was true that it was, at the base, an American company, responsible to American shareholders and subject to inspection and questioning from the Securities and Exchange Commission and the Internal Revenue Service; but that control was diminished by ITT’s global scope. Soon after he became president, [Harold] Geneen held a special conference of his top lawyers and accountants, to discuss how ITT could best make use of the tax havens outside the United States to cut down on its American taxes. The experts were doubtful, but Geneen insisted that ways could be found; and ever since then, ITT has surprised other companies’ accountants by the smallness of its taxes…*

As the author observes:

All conglomerates, when they shot up in the sixties, benefited greatly from the confusion of accounting methods, and the flexibility of the Generally Accepted Accounting Principles (GAAP).

Hot Pants Accounting

Later:

The obscurantism of conglomerate accounting has aroused increasing criticism from inside the profession. One of the most outspoken critics is Abraham Briloff, professor of accounting at Baruch College, New York… He sees conglomerators like Geneen as cowboys who invade the territory of the farmers, sell off the topsoil, and ruin the land; they expand by raping, reaping, bedazzling. He complains about “hot pants accounting,” which reveals the exciting while concealing the essential.

*It is fair to say that ex-post the low level of conglomerate taxes reflected the low level of underlying profitability - rather than the high level of stated profitability. When you see a company that earns $400 million but pays only $750 thousand tax you have to ask whether it has very clever tax accountants or grossly overstated financial accounts.

[$400 million profit and $750 thousand tax was Bond Corporation in its final year. The right response was "profit - I do not see any profit".]

Wednesday, March 18, 2015

Before I went away I left people a puzzle - to force people to understand the Herbalife compensation scheme.

The puzzle was - and to quote:

Imagine you were the very first Herbalife distributor and you recruited three people and they - eventually and through their downline - recruited the millions of people who now consume and/or distribute Herbalife.

And also presume you did nothing else for the rest of your career. You just sat there and collected the "recruitment rewards" or the "royalty checks".

Roughly how big would your income be now? And from how many levels would you be collecting your income?

The reason that I posted this puzzle was that short-sellers (broadly defined but starting with Bill Ackman's original Herbalife presentation) have publicly said many false things about Herbalife - and one area of these falsehoods has been the remuneration scheme.

Specifically Ackman thinks that the scheme is designed to push large purchases of unsellable weight loss powder and enrich Herbalife and top distributors while defauding mostly poor Latinos.

And the guesses I have received for the answer conform to this suggestion. The typical guess was about $3-5 million per year. Christine Richard - one of the key outsource researchers for Bill Ackman was in the middle of that range (at $300,000 per month). I got one estimate of upward of $50 million per year.

These estimates are based on a false assumption - an assumption promulgated by Bill Ackman. The assumption is that Herbalife's compensation scheme is a conspiracy to enrich top distributors at the expense of middle and low level distributors.

This is to misunderstand the motivations of Mark Hughes who founded Herbalife.

Mark Hughes is a character about whom people have strong opinion. I have seen everything from a flat-out man-crush to utter revulsion. But whatever you say about him you have to confess he was a clever businessman.

He invented a monstrously complicated compensation system for Herbalife distributors - and it was invented to benefit his company and not the early distributors. He did not wake up one morning and say I will make these early distributors rich for life for just sitting around.

Mark Hughes wanted Herbalife to sell a lot of product. He did not want to pay distributors to sit around and do nothing. Indeed the scheme is designed so that if you do not stay active selling your income eventually tails towards zero.

Here is how the scheme actually works (and this is a simplification but these are the core ideas).

If you are a base level distributor you buy the product at a discount of up to 42 percent. You sell it at retail. You make a margin.

At some point you become a sales leader. A sales leader is entitled to buy it at up to 50 percent discount. You can NEVER buy the product at a higher discount than 50 percent.

But the sales leader is entitled to a royalty. The royalty is paid three levels deep. A recruits B recruits C recruits D recruits E then A is entitled to 5% of BCD but not E's sales. B is entititled to 5% of CDE sales. That way 15 percent more is paid out.

This you are always entitled to - three levels deep.

After that there is a "production bonus". These are up to 7% of sales based on your level. However if someone in your down-line earns 2% production bonus then you are only entitled to 5%. And when your down-line is long and successful enough the entire 7% will be earned below you. You will be blocked and receive no income.

After that and if you are senior enough you may receive the Mark Hughes Bonus - typically 1% of all sales paid infinitely deep in the sales structure. HOWEVER if someone in the Chairman's Club is below you (and this happens) then you get blocked on that too. So you will receive no Mark Hughes bonus.

The person I describe could never be in the Chairman's Club (to do that you need 5 people below you to make a certain level) but someone who was very early and has done almost no recruiting will almost entirely be blocked on the Chairman's Club as well.

So lets calculated the answer...

They do no sales - so they get no retail discount.

They have people three levels below them - so they receive 5% of their production - but their immediate network is either senior and doing few sales or sclerotic). This is the only income they get - and it is 5% of three levels.

They are unequivocally blocked on the "production bonus" so they get nothing there and
They are not Chairman's Club or above because they recruited only three people - and if the recruited more they would be blocked for most of it anyway just because the very early guys have all been blocked out unless they kept growing their network.

So all they get is 5% of three levels down - which is likely to trivial - probably less than $5000 a year.

Note the 50% plus the 15% plus the 7% plus the 1% is the famous 73% payout ratio. It all gets paid - just not to the foundation recruiter. In fact it gets paid to people they recruited, people who worked hard to build networks and make more sales.

The scheme is deliberately designed to reward active people who are growing their network not old codgers at the top. It is complex I will concede - but the complexity is designed to do almost precisely the opposite of what Bill Ackman claims it is designed to do.

How did the Ackman crowd - including Christine Richard get this so wrong?

According to the Wall Street Journal Bill Ackman's researchers are currently getting investigated for (possibly) lying to investigators about Herbalife.

And they have told untruths about the Herbalife compensation scheme.

But the scheme is complicated - and they looked at the scheme and saw what they wanted to see (ie evidence of a pyramid scheme benefiting the very top) and not what is actually there (a scheme designed to incent sales).

This was self deception - but it was self-deception aided by some Herbalife distributors who say you can build "residual income" by recruiting a large network. When distributors talk about sustained residual income they are not telling the truth.

Still there are resources on the web that help you understand it. There is one distributor who is trying to sell MLMs that are not Herbalife - arguing that there is a "flaw" in the Herbalife system that denies you residual income. They want to sell you an MLM that really is a pyramid. To quote...

Now it’s down to infinity until the next level ranking Distributor at your level reaches your level. So if I’m a President’s Team member or a Millionaire Team member and I have somebody underneath me that hits Millionaire Team member, then I’m blocked off of that production bonus.

Now how the production bonus works with the Herbalife Compensation Plan is let’s say I’m a GET Team member and I have 20,000 organizational volume points, I get a 2 percent production bonus. I’m going to get 2 percent all the way down to infinity until somebody reaches the GET Team status underneath me. Once they reach the GET Team status underneath me and if I’m GET Team myself, not advancing to Millionaire Team status yet, let’s use that as an example, then I would be cut off or the breakaway of my production bonus would take place.

So the only time that you earn production bonus is when people are not at the same level as you. So if I’m a President’s Team member and I am earning a 6 percent production bonus, and I have somebody underneath me and my team that is a Millionaire Team status, the Millionaire Team status member would get the 4 percent production bonus and I would get 2 percent because there’s a total of 6 percent paid out, and that 2 percent production bonus I would earn until that person reaches the same rank. In the example, if I was President’s Team, once they reach President’s Team, I would be cut off from that production bonus.

One of my main things that we teach here at XXX is that you should never be penalized for developing leadership. You never should be in the fear that your income is going to drop based on someone advancing to a higher rank.

This is one of the key reasons of course why Herbalife is not a pyramid scheme. Any new member can reach the higher level - though very few do. It is really hard to develop an organisation that sells hundreds of thousands of dollars worth of Herbalife per month. Though every month in the US a few more people get inducted into the President's Team. And every month upper level distributors have their income reduced somewhat.

Sunday, March 15, 2015

At Bronte we have a large position in Rolls Royce - the UK based manufacturer of jet engines.

Rolls is a relatively simple story - Rolls is part of a duopoly in engines for wide-bodied aircraft (aircraft with two aisles like the Dreamliner, A350, A380, 777 and forthcoming 777X).

Jet engines cost a fortune to develop and are sold at a loss - but with huge out-year maintenance streams.

The maintenance is potentially very profitable. If you sell a lot of copies of the jet engine maintenance margins can get very fat.

This duopoly is almost impossible to break. Not only would a company need to spend billions of dollars before they developed a competitive engine they would then need to sell the engine at a loss for many years until the maintenance streams come on.

Moreover it is risky.

If you attach your engine to an unsuccessful plane (like say the A340) production will be a few hundred copies - and you will eat all those development costs for smaller maintenance streams and you will not get scale on maintenance. Making unsuccessful engines or attaching engines to unsuccessful planes is a good way to lose a lot of money.

Contra: if you attach your engine to a hit plane like the 777 - especially if it is the only engine choice for that plane - you will make thousands of copies of the engine and develop scale in maintenance. And that is profitable in the billions - and maybe even tens of billions of dollars range.

Rolls has had a few less than successful planes in recent years - let by the A340 but probably including the A380. (The super-jumbo is wondrously fuel inefficient.)

--

The bull story revolves around the A350. On paper this new plane is the most fuel efficient long-haul plane in the world - and if that is true it should - over time - receive thousands of orders. (The current order book is slightly over 800.)

On paper Boeing's forthcoming 777X is a match for the A350 in fuel per seat kilometer - but that plane is still a paper plane. It has not flown yet.

Rolls Royce is the monopoly engine supplier to the A350. GE the monopoly on the 777X.

At Bronte we spent considerable time trying to work out whether the A350 was as fuel efficient as it was claimed to be. (Other planes, notably the A380, have not met spec.)

If the A350 meets spec and does not fail on safety then Airbus will sell many more than the current forward order book and Rolls will have a super-successful engine on its hands. Revenue will more than double over time. Operating margins will probably also double. Rolls Royce stock will be a big winner.

A test flight came through Sydney and we tried to get the fuel loading statistics from the airport. (No we are not kidding. Alas the plane was refueled by Virgin Australia and not Qantas. I could not get through.) We had other methods to try and assess the numbers too.

That question really comes down to carrying capacity. The A350-900 is claimed to be able to handle 314 passengers fully loaded. No plane has yet been fitted out with more than 300 seats but some are being delivered later this year with 306 seats.

If the plane is overweight (because it does not meet specifications) then it won't be able to carry that much load. In that case the airlines would need to spread the seats out. Passengers love this (more leg room) but airlines hate it. Fuel efficiency is compromised.

Alas the plane that came through Sydney was fitted out with about 260 seats - it was really spacious. This could have been because the plane was overweight - or it could have been because they wanted the plane to appear spacious as Airbus was merely drumming up orders. We could not tell.

--

We finally have a definitive answer. We have discussed the matter with pilots who have seen the training manual. That includes take-off weight specs and fuel specifications.

The plane is as good as its specifications.

And Rolls Royce should be a great stock.

This is old-fashioned in-the-weeds stock research.

--

There is a bad bit to Rolls Royce though. It has a business in very big diesel engines - sometimes used on ships but even more pertinently used in the stabilizer motors of large oil platforms. All of this business looks pretty bad at the moment - the cycle looks bad - and the barriers to entry look far lower than the core jet engine business.

Moreover there is no A350 on the horizon - no world-beating product that should make lots and lots of money.

It is this business - and the seeming willingness of management to commit more capital to this business - that is the bear case for Rolls.

It is also really the reason why Rolls Royce stock is a bargain.

And I have never really heard a decent explanation of why Rolls has continued to commit capital here.

But now I am hearing the whispers of activism. The latest Sequoia letter is pleading for activism. To quote:

Rolls-Royce, our largest UK position, seems willing to destroy shareholder value in the name of diversification. Rolls-Royce has a world class business making engines for wide body jets. These engines are often sold at breakeven prices, or even a loss, but come with long-term Total Care service contracts that are quite profitable. Rolls shares a duopoly with General Electric Company (NYSE:GE) in wide body engines and the barriers to entry for any newcomer would be formidable. Not only is the business intensely regulated, but a new player selling jet engines without an installed base of profitable service contracts likely would lose billions of dollars to capture market share from GE and Rolls. Not surprisingly, Rolls earns more than a 20% return on invested capital in civil aviation and its installed base of service contracts and strong backlog suggest Rolls should grow profitably for years to come.

And yet Rolls’ board of directors decided that it wanted to diversify deeper into the marine engine and power generation businesses, competitive sectors that are being encroached by low cost Asian players. To pursue this strategy, the board appears to have pushed out a sitting CEO who had crafted the successful Total Care service contract selling model, and replaced him with John Rishton, a board member who, in our meetings with him, has shown minimal awareness of the returns on capital his acquisitions have generated.

Rolls’ stock declined more than 30% in sterling during the year as investors lost confidence in management. We held our shares in the belief that Rolls’ wounds are self-inflicted and reversible. The recent share price does not properly value the civil aviation business even if we ascribe little value to the marine and energy businesses. However, management and the board seem stubborn and entrenched, and it may take a tough-minded activist to force strategic change.

I am a little happier with John Rishton. The market hatred of the man has allowed us to buy Rolls cheap. But whatever - he has a little explaining to do or the activists will get rid of him kind of fast. If the whispers get to me they have really got around Wall Street. I am kind of low on the pecking order.

Friday, March 13, 2015

[the investigators are] looking into whether people, including some hired by Mr. Ackman, made false statements about Herbalife’s business model to regulators and others in order to spur investigations into the company and lower its stock price.

There is a presupposition here - which is that the Feds believe that the story told regulators is false.

Thursday, March 5, 2015

I am just about to get on a plane to China and Hong Kong - so I will be away for a little while.

However I have a puzzle for all you Herbalife junkies out there... and it might require you do some research.

Imagine you were the very first Herbalife distributor and you recruited three people and they - eventually and through their downline - recruited the millions of people who now consume and/or distribute Herbalife.

And also presume you did nothing else for the rest of your career. You just sat there and collected the "recruitment rewards" or the "royalty checks".

Roughly how big would your income be now? And from how many levels would you be collecting your income?

The shorts have played these elements up - and combined they meant that the cash flow was sequentially far less good.

The good element (which the company played up) was

(c). distributor numbers and retention went up sharply.

In the past distributor numbers and volume have been very tightly correlated.

They are no longer tightly correlated.

Inevitably they will become correlated again - but the question is which direction. Will volume growth rise to match distributor growth or will distributors leave disillusioned?

On this the Herbalife debate will hinge. [The bears will argue the FTC will also be an issue - but I doubt that strongly.]

An interpretation of the results in the light of Herbalife corporate rule changes

The company implemented three core rule changes which were trialled first in Eastern Europe and which I have cross checked with some Eastern European distributors.

These are

i). Requiring that you qualify as a distributor slowly - ie there are no 4000 point success builder orders any more. Note that this rule change slows orders down.

ii). Requiring that the first qualification not be by "field sales" - you must buy from the company (note this slows orders down in Mexico and other countries for reasons that will be seen below).

iii). Requiring that if you sell via a website you do it under your distributor label (you get paid) on the GoHerbalife.com site. A delivery is then made direct to the customer obviating the need for the distributor to hold any inventory - and hence allowing de-stocking of distributor inventory and thus slowing current sales.

Why these rule changes

There are several reasons they implemented these rules.

One reason is that if a distributor qualifies as say 4*$1000 orders she is more likely to stay around than a distributor qualifying by a single $4000 order. The upline can then focus training on distributors who are more likely to stick around. This means new distributors become more effective.

A second (and possibly more important reason) is that they are very good at fending off Ackman's complaints. Slowing initial orders is antithetical to inventory loading (and inventory loading a required component of declaring Herbalife a pyramid). More importantly the third rule change obviates the need for any distributor inventory - and is a complete protection against a claim that Herbalife is a pyramid.

A third reason is about control of the business - particularly in developing markets. For example, in Mexico the up-line distributors have built warehouses all over the country - there are three Chairmans Club members who own the warehouses. The Chairmans club members can distribute Herbalife to you same day anywhere in the country almost everywhere - even with crappy Mexican logistics.

This is good for Herbalife (as they get lots of sales) but they are a risk for Herbalife - in that the Chairman club members might defect to a competitor taking their warehouses, customers and downline with them.

To "own" the customers Herbalife wants distributors to qualify with sales direct from the company. They are banning "field sales" for qualification.

Moreover Herbalife is building its own warehouses over the country. As it does this its distributor warehouses are being (to a small extent) de-stocked and its own warehouses are being stocked. The de-stocking of distributor warehouse is a drain on current sales and the stocking of its own is a costly inventory build.

All of these things should (i) make Herbalife stronger and (ii) explain the falling sales, increasing inventory and simultaneously increasing distributor numbers.

And if this interpretation is correct Herbalife should come back growing volume with a vengeance.

Tuesday, February 24, 2015

Maximus (NYSE:MMS) is a large cap and highly valued government outsourcing company based in Reston Virginia (outer suburban Washington). Its second biggest market by revenue is Australia (and I think by the amount of cash trapped in Australia in presumably depreciating Australian dollars the Australian arm has been particularly profitable).*

The stock chart is - well - ballistic. This is a market favourite:

Here is the revenue split from the last Form 10K.

We operate primarily in the United States, Australia, Canada, the United Kingdom and Saudi Arabia.

Our revenue was distributed as follows (in thousands):

Year ended September 30,

2014

2013

2012

United States

$

1,306,026

$

999,419

$

775,871

Australia

170,727

157,383

163,482

Rest of World

224,159

174,477

110,792

​

​

​

​

​

​

​

​

​

​

​

Total

$

1,700,912

$

1,331,279

$

1,050,145

​

​

​

​

​

​

​

​

​

​

​

​

​

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​

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​

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​

​

​

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The Australian revenue is from a government outsourced employment agency business.

To get welfare payments in Australia you need to be actively looking for work (and sometimes need to appear at minimal job-readiness courses and the like). Until 17 years ago the government had a large bureaucracy (The Commonwealth Employment Service) who administered this.

The CES was effectively privatised with private sector organisations (and sometimes charities such as the Salvation Army) taking this function. The function included sometimes kicking welfare recipients off welfare (something that made the business difficult for some charities).

Last night the Australian Broadcasting Commission (the Australian equivalent of the BBC) aired a program on how this program is working. This was done on "4 Corners" which is far-and-away the lead current affairs program in Australia.

It was not pretty.

To quote:

"There are credible claims of widespread rorting by some agencies.... we have now completed an investigation which suggest that significant fraud, criminality is going on."

Later it suggested that only 40 percent of the fees paid to agencies were against verifiable activities. The widespread practice of falsifying signatures, falsifying job interviews that unemployed people attended and falsifying disabilities of the unemployed was exposed. [For example an agency collected larger fees for working with more "disabled" people so there was a tendency to suggest people had mental illnesses or the like. More regularly signatures were faked using cut-and-paste methods to show unemployed people attending interviews that they did not attend or training courses that they did not attend and hence to rort fees from the Government.]

The number one target of 4 Corners was a domestically owned organisation called ORS. The evidence (if true) was utterly scathing.

Max Solutions - the Australian business of Maximus - was the second biggest target - but to be fair the claims made against them were far less scathing. Still they alleged that Max was directing unemployed to fictional training programs owned by Maximus and hence rorting the government. For instance they suggested that Max Solutions had enrolled 115 people in a training program in a room that could physically only take 15 people. [They were presumably - although this is not stated - faking attendance or even enrolment records or else they would not have got paid for these services.]

We are currently in the process of rebidding on much of our work in Australia. We anticipate that a new contract will commence during the fourth quarter of fiscal year 2015. These contracts are likely to have more contingent revenue streams, less up-front fees and will likely incur losses in early quarters. However, we anticipate that the contracts will be profitable.

It isn't much fun to face such accusations by the National Broadcaster as you are rebidding all your contracts.

John

*$220 million in cash is held in currencies other than the USD. Given the Australian dollar has been very weak that hasn't been particularly nice.

Saturday, February 21, 2015

Martin Shkreli was formerly a biotech short-seller. I know those people. I am one.

They have their eye out for the inflated claim re the efficacy of a drug and the wheeling and dealing in stock.

Unusually Martin became CEO of a biotech (Retrophin) and became a wheeler-and-dealer himself. Martin also kept a twitter account where he recommended Retrophin stock and suggested (often correctly) that other biotechs were worth shorting.

He is a 31 year old - but all the photos make him look 17. The joke about his hyperactive twitter account was that he would tweet if he had a date.

Today the company released an 8-K explaining what the board found after his ouster - and it is already being described as an epic. Here goes for some of it.

Consulting Agreements. Between September 2013 and March 2014, the Company entered into several consulting agreements and releases with individuals or entities that had been investors in investment funds previously managed by Mr. Shkreli (the “MSMB Entities”), or that otherwise had financial dealings with Mr. Shkreli. The agreements provided for the issuance of a total of 612,500 shares of common stock of the Company, and a total of $400,000 in cash payments by the Company. The Oversight Committee concluded that the Company should not continue to treat these agreements as consulting agreements because their predominant purpose appears to have been to settle and release claims against the MSMB Entities or Mr. Shkreli personally, and not to provide meaningful and sustained consulting services to the Company.

And

Litigation Settlements. In the second quarter of 2014, the Company settled two lawsuits involving individuals who had formerly performed services for both the Company and the MSMB Entities. The Oversight Committee concluded that approximately $200,000 in cash payments made by the Company as part of these settlements appear to have been made to cause these individuals to transfer 176,388 shares of the Company’s common stock directly to Mr. Shkreli.

Thursday, February 19, 2015

We are having one of our irregular looks into Spark Networks - the owner of the profitable J-Date dating site (and the unprofitable "Christian Mingles"). J-Date is a Jewish match-making institution.

One step of course is to get the young (and conveniently Jewish) intern to sign up and research possible dates.

There is not that much activity (especially in Sydney) and some profiles are difficult. My favourite:

My personality is best described as high maintenance.

Seeking advice but J-Date doesn't look like it has much traction with the young (although its proponents argue it is a marriage site and hence of interest to people older than our intern and competes less than brutally with Tinder).

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.